annenberg media ♪ annenberg media ♪ 1931. the great depression. banks were failing by thousands. the federal reserve, created to prevent suca tragedy, only made things worse. what had gone wrong? 1951, during the korean conflict, president truman also faced another battle, between the federal reserve and the treasu, over financing the war. how would it be resolved? 1965, lyndon johnson's administration was spending on both a war and a greasociety 1965, lyndon johnson's admiwithout raising taxes.g

the fed was left to fight e resulting inflation alone. the nation's central bank, originally created to protect the banking system against panics, acquired more power to affect the economy than even it imagined at theutset. the federal reserve: does money matter? with the help of economic analyst richard gill, we'll explore that question on economics usa. i'm david schoumacher.

coins, bills, checks-- our basic money supply. the amount of money and where it goes wiin the banking sysm has en the main concern of our nation's central ba. at t fed's heauarters here in washington, dc, closedeliberatio are held bs who continuously monitorourh and prescribe remedies. how did these experts prescribe a remedy that plunged us even deeper in the great depression? early in the0th century, american banks operated with little regulation and great vulnerability.

in 1907, that vulnerability became apparent when depositors lost confince short-termoa,tir money.e nkt and many colpsed. it took a powerful bankenfince short-j.p. morgan,oney.e nkt but should an entire country be dependent on an individual's whim? a central bank, a lender of last resort, seemed better solution. just before christmas of 1913, esident wilsonigd e federal reserve act. it created a federal reserve system. though its real operating powers residein 12 regionalanks, its official headquarters was in washington, d.c. merritt sherman, active with the fed since 1926, describes one of its early tools to regulate banking activity-- the discount rate. that was the first tool used whenhe fed was created,

the discount rate being the rate that is charged to member banks when they need to come in toet additional reserves. and it is raised to restraitheir borrowing, lowered to encourage their borrowing. through world war i, through the roaring twenties, most and went abouttheir bu. the system was safe then one day, it all came tumbling down. october 24, 1929, the greatest stock market crash in history marked the beginning of years of economic devastation. banks failed by e thousands. the fed failed its major test.

we asked economist lester chandler for an explanation professor chandler, the fed was set up to pvent bank failures and avoid depressions, all of whichappened in the 1930s. whatent wrong? within the federal reserve system, nody knewwho was too what where the resee actreserve was coerneystem, r one cel bankwnthe aldricpn wihes aat wasupposetoosomeing cen, oa fel reserve ar t they coun'cidewho was do. i'll we didt vey. very many central bankers aat wasupposetoosomeing cen, oa fel reserve ar in this country in 1914. central baing was not a recognizedssion.

fearful that the united states was not a safe harbor, foreign investors withdrew their gold deposits in a srt time,$30 milli. from american banks. we asked dr. andrew brimmer, former member of the federal reserve, why gold alarmed the fed. dr. immer, in 1931, foreign investors were pulling their gold out of american banks. reserves were being depleted. what does that doto? what does e reserve do to try to combat it? for the banking system as a whole, if there's a sigficantreduc, from whatever source, it has to cut back on loanseduc, and the extension of credit unless it can ge some relief. only t federaleserve, acting as a central nk, can provide more relief. so, in931, as the goldve, flowed to europe and so on,

that was a loss in reserves the centraba had to make it u the fed would not stand . itaiseits scouate orceanksase i the centraba the sult--foreiginvestors the earned more interest. itaiseits scouate orceanksase i and left their money in u. banks. th ended theoldrain. burag thdiscount rate had other, less fortunate, consequences. if the federal reserve raiseshe discount rate, that transmits a message banks and theoney market that it wants to be restrictive. for the economy as a whole, the result was disastrous. high interest rates discouraged borrowing, choking off business credit. more businesses failed, more jobs lost, and more banks collapsed.

the country was pushed deeper into the great depression. well, professor, if you graded the fed-- a, b, c, d, f-- what would it be in the 1930s? i would grade it as an "f" applying today's standar. probably a "d," applying even the standards-- the most advanced standards of tt day. sure, you can criticize the d. it made mistakes. but what it did wrong was a matter of degree, mostly, ther than... total mistakes of policy. the men who met around this table were some of t country's most influential bankers. they were the federaresee'sard. were some of t country's when they met to changediss most influential bankers. ey senripples across theation. they were practicing a rudimentary form

of monetary policy. they were affecting the money suly how important was the money supply? economist richard gill has an anasis. to understand this question, we neesome sense of how t moneyupply affects the economy's general workings and how the fedcaaffect the. this diagram suggests the general nature of the answers theseuestions. theotically, in a depression situation, the fed should increase reserves available to the commercial banking system-- provide more reserves, as stated in the first box. the hope is that banks will lend more credito businesses, thereby increasing the quantity of money in the economy. more money, in turn, should lead to more spending by businesses who have borrowed to invest in new machinery and factories,

possibly also by consumers like ourselves. more spending, in turn, shouldead to higher gnp and more jobs. it may also lead to higher prices, though that didn't seem a problem then. 1930s prices were generally falling. when the fed tried to stem the gold outflow by raising the discount rate in 1931, it was doing the opposite of what this analysis suggests. it made it more difficult for commercial banks to borrow, creating a negative effect on reserves. in fact, during those years of the depression, the country's money supply shrank drastically. a mber of economists today believe the fed's misdirected policies were a major factor in turning an ordinary downturn into a great depression. we quickly add, however,

thatost economists cameo a different conclusion.ng theyoncluded that there was litt fed could have done at twould snapuggested in a serious depression.am thatost economists cameo a different conclusion.ng the fed might make more reserves available, but the banks might scared to le them and businesses too frightened to borrow. evenf more money wereomehow created, peopleouldn't spend it. in such treacherous times. a strong desire for liquidity hence, more money might not mean more spending. but without more spending, would necome into ay.ht not to raisingnp and employmen in fact, for many years, monetary policy was generally in dispute in this country, particularly when it came to curing business downturns

you can lead horse to water, but you can't make him drink. such was the common opinion. our great new federal reserve system, ke tcomy it whad come upon hard times. the banking act of 1935 ga theed the authority iteede it also ovided the fed win impoant tool--my1935 toxercise its authorityd atd open15ears later,tio diey conflict wi the treasury? ouunion is asking itsembe to invest every dollar it can win these bonds. and with god's help and your dollars, we'll win this war. in world war ii, asarof its open-market operations, e fed bought treasury bos to help finance the war.

fed officials felt that providing that service was essential to victory. as we entered worlwaii, the federal reserve undertook a commitment in january 1942 to support the market for government securities. it would buy and sell all the governme securities anybody wanted to offer on the market to keep interest rates from rising. the fed bought bonds the trd that the public didn't buy. dr. brimmer explains more on how open-market operations affect the economy. open-market operations consist of purchase or sale of government securies. the resees are the basiss.sales. for expaing loans ry important activity. expanding moy and credit.

pumping so much moy into the ey ry important activity. expanding moy and credit. did not lead to inflation because the economy had room to expand and because strict controls were imposed on wages and prices. after the alliedictory, the treasury insisted on keeping the same arrangement, and the controversy began. the dit wasnclearere merely w ngt would continuey's agent as far as e conduct ofmotary por the treasury straitjacketed the fed. why were their interests in conflict? as the economy expanded after the war, the demand for credit rose banks found an opportunity to lend to private companies, individuals, and so on. where will they get the reserves, the cash to do that? sell your government securities.

these were very low-yielding-- 2.5%, 2.75% interest. you could at 5%-6% to prite borrowers. sohe banks, insurance companies, others, began to sell off government securities. the federal reserve was committed touy them because ofhat legacy of war commitment. as it bought securities,it adde. that gave the banks the basis fonew lending. so the banks would lend, sell securities, get the deposits, make more loans. that was aing to an enormous expansion inhe money supply the federal reserve was afraid of bank credit. that such an expansion of money and credit the would lead to inflation.id of bank credit. theninune of 1950, fighting broke out in korea. a limited, but very costly war,

it brought out the treasury-fed conflict. the treasury is part of the executive branch. the feral serve is an indendent agency, createby congress, with independence of the political pressures from the white house. in that sense, the treasuryouot mante instructions the federal reserve. chairman thomas p. mccabe believedhe fed's role was to restrain inflation. treasury secretary john snyder and president truman wanted the fed to help finance the war. president truman, in his memoirs, described the experience he had in 1917. he bought liberty bonds. heidn't know, and most people didn't know, that those liberty bonds, c, went up and down with market ices after the war, interest rates rose, bond prices fell,

anma people had toell bonds below what they paid for em. truman never forgotthat eer. he thought the government shouldn't cheat people. truman called the federalope to the white house for a tongue-lashing. never before had a president to ttried so directly to influence fed policy. there was so much misunderstanding on both sides that truman ordered a commission study the matter. rather than let a third party dictate a settlement, the fed and the treasury met on their own to find a solution, resulting in e accord of 1951. the federal reserve would be free to control money and credit without havi to buygovernm. the treasu agreeto issue someonmarketable bonds at carried a somewhatigher interest rate.

as in any ttle, ere wereasualties. thomas p. mccabe resigned under pressure from truman. he was replaced by william mcchesney martin, a key negotiator of the accord and a treasury undersecretary. following the accord, the fed was free to conduct monetary policies unhampered by treasury constraints. the fed had flexed its muscle and won. using open-market operations in the fifties, it proved to be very effective in combating inflation. the relationship with the treasury became more equaland sy. for more on open-market operations we talked with richard gill. when the fed made open-market puhases of government securities as it did prior to 1951, it was effectively increasing the reserves available he commercial banking system. and thus potentially making more money available

to the economy in general. here's how it works. the fed purchases,ay, bilfrom the treasury.on it pays for these bonds by adding 1 billio to thereasury's account. the treasu uses is to write checks toeople who are providing services to the government. ese private individuals sit ese checks these deposits become part of these banks' reserves. with these neweserves, banks can create more money. is is very muc like pnting-press money. the fed was sayingatheime oy may have been appropriate inepressioyears,

but was longeappropate aeconome it waslso serving noceatheime oy thatonetary policydeies.e mighnobe soeak a ol as oe imaginedappropate aeconome it waslso serving noceatheime oy thatowe worked for two centuries to climb this peak of prosperity, but we're only at the beginning of the road to the great society. great society notwithstanding, there was also the matter of fighting a little war in a place called vietnam. this is e memorial tohat war, an undeclared war whose full cost was kept secret could moneta policy alonent's harness the runaway inflation caused byguns-and-b?

meant we would try fighting abroadar without any major sacrifice of social programs at home. war spending spurred the economy even higher. factories reached full capacity. labor was inemand ancould command higher wages. here were sown the seeds of inflation. i beeve we can continuehe greatociety while we fight in vietnam. the milita cefs were asking for more money yet president johnson rejected a tax increase. we asked his economic adviser, james duesenberry, why. we had, after all, just gone through a big program of tax reduction, sohaturning around did not appeal to m. t i think a moignificant matter was that it brought the issue of the vietnam war

into a very sharp political focus. william mcchesney martin, then chairman of the federal reserve, had very good contacts with the pentagon and through e federal resee system,rs. those directors and anches all around the cou, the informationwas pou, showing that the economy was heating up. to martin, inflationasmoren a s. it was a present reality. to mthe federal reserve board s. decided to fight it. in december 1965, they raised the discount rate. johnson hit the ceiling. he announced publicly he would call bill martin, the chairman of the federal reserve, down to the ranch for a tongue-lashing.

but raising the discount rate didn't keep inflation from growing. it breaks my heart to go shopping. the war kept growing, too. when neither the administration nor congress applied fiscal restraints, the fed decided to go it alone again. they used an open-market operation. in january 1966, they sold government bonds to tighten up the nation's money supply. interest rates rose dramatically. soon, any business sensitive to interest rates was caught in a credit crunch. the housing industry was hardest hit. the full effect of the fed's solitary action took hold in early 1967. inflation dropped, but at a terrible cost-- a zero growth rate for the gross national product. to economists, this was an impressive lesson.

the fed was very effective in 1966. the discount rate increase and the reduction in the rate of creation of bank reserves drove up market interest rates, reduced investment in residential construction by several billion dollars. that served to offset, from a broad economic point of view, the increase in vietnam expenditures. i later, years later, asked president johnson what he really thought of that episode. he said, "you know, andy, bill martin was right, but he should have told me about it ahead of time." the war, fought half a world away, ed evespec ofmecan omeoe titions.the ay significanwe buon agrcost

we askedomntatorchargill, o economne policy?"mrtt was certainly by the mid to late 1960s, everybody realized monetary policy was important. even in the old days, most people realized that although you can't push on a string, you could pull on one. in an economy beset by inflation, the reverse links, reduced reserves, to less money, to less spending, to lower prices, worked well, perhaps too well. we might get not just lowered prices, but also lowered real gnp. and not just lowered real gnp in general, but higher interest rates and the collapse of interest-sensitive industries like housing and commercial construction. the crunch in the credit crunch of 1966 was for real.

monetary policy, it seemed, was a lot stronger tool than many had imagined. there was a general rethinking of the whole subject of money and its relationship to the economy. perhaps money mattered in depressions as well as inflations. the keynesian consensus that emerged from the 1930s was beginning to break up. the fed was created as a banker's bank, but it has developed over the years into an institution with a much broader mandate. monetary policy has evolved in response to the demands of history. the great depression showed the fed didn't understand its own power. the korean war underscored the need for the fed's independence. the vietnam era's inflation graphically illustrated both the power and the problems of monetary policy. there's a good deal more to monetary policy.

we'll be returning to it again in future editions of economics usa. i'm david schoumacher. captioning performed by the national captioning institute, inc. captions copyright 1986 educational film center

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annenberg media ♪ annenberg media ♪ in the early 1970s, battles raged in the middle east. and throughout the world, disastrous weather caused crop failures of immense proportions. why did these two events affect inflation and unemployment in the american economy? u.s. society was besieged by the twin assaults of inflation and unemployment in the 1970s. why couldn't the government achieve significant success against the ravages of stagflation? in the late 1990s, the economy was booming.